In this paper we develop a simple theoretical model for CDS spreads and empirically test its implications using the actual changes in CDS spreads based on 436 U.S. firms from 2002 to 2011. Individual firm default risk and their stock illiquidity are significant predictors for changes in CDS spreads. The impact of an individual-liquidity factor is asymmetric and pronounced only if liquidity dries up. Market-wide factors, such as systematic liquidity and credit risk derived from the CDS market as a whole, are, however, more important determinants of individual spreads than firm specific information. The proposed model performs well for cross-sectional predictions and can be used to approximate spreads for firms that do not have CDSs. It, however, challenges the proposition of Basel III to use CDS spreads as a pure proxy for counterparty default risk, as systematic factors are the dominating drivers of CDS spreads.
|Publication status||Published - Nov 2015|